Among all debt funds, credit opportunity funds stand out at present. They have outperformed all other fund categories in the last five years. One-year average returns of these funds are at 7.5 per cent, three-year at 9 per cent and five-year at 9.4 per cent. The returns look all the more attractive when yields on bonds are volatile, hitting returns from other debt funds.

But before you rush to invest in these funds, understand the risks they carry and whether you have the appetite for them. Higher returns in an investment product come from taking higher risks. In the case of credit opportunity funds, the risk lies in the companies they invest. They invest in bonds that have higher yields, but the credit quality is lower.

While credit opportunity funds can be a part of the retail investor’s portfolio, investment managers and analysts suggest that investor needs to first understand if they are willing to take the risk that comes along with these funds. “Traditionally, investors have not looked at the underlying portfolio when assessing a fund thought it’s important to understand the break-up of the portfolio. The returns have come obviously because they have taken higher credit risk,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor India.

There will be funds that are invested mostly in double-A and A kind of papers. There will be other more aggressive ones that hold most of their portfolio in A-plus, A, and A-minus sort of papers. Opt for a fund whose level of risk you are comfortable with

To deal with the higher risk in these funds, investors also need to be conservative in their allocation to them. Most retail investors in debt funds are recent converts from the fixed-deposit space. They should build a core portfolio that is conservative both on duration and credit. It’s best to keep the bulk of the investment in shorter duration funds (70-80 per cent) unless the individual is investing in debt as part asset allocation for the long term. Long-term investor can look at dynamic bond funds, where fund managers change the portfolio depending on the market situation. Allocate a small portion of the investment (20-30 per cent) to credit opportunity funds that may help them earn higher returns by taking extra risk.

Investors may be better off investing in credit opportunity funds belonging to larger fund houses. Bigger fund houses have the ability to absorb the hit in case of a default, so that the NAV (net asset value) of their fund does not get affected. Larger-sized funds also tend to be well diversified.

Other investment advisors say that investors should opt for a fund house that has an established team which can carry out primary research into the companies their fund invests in to be able to understand the possibility of default risk, instead of relying on ratings alone. Also, check the fund manager's track record in managing this kind of a strategy.

Do pay heed to the exit load of these funds, which could be applicable for two-three years. If you need to exit after one year, you may end up paying a one per cent exit load, which will eat into your returns.